Bond investors should prepare for higher volatility as change comes to the Fed

Two of the seven seats on the Board of Governors have been open since 2013 as nominees never made it as far as confirmation hearings. Fed Governor Daniel Tarullo, who heads supervision and regulation, has announced plans to retire in April. In addition, Fed Chair Janet Yellen's term as Chair will be up in February 2018 while Vice Chair Stanley Fischer's will be up in June 2018.

Assuming Yellen will not be reappointed, the Trump administration will have the opportunity to replace five of the seven members of the Board of Governors over the next 15 months. (Yellen and Fischer could stay on as members of the Board of Governors for several more years, but it appears unlikely.)

The anticipated shake-up could change the way the Fed sets policy, with the central bank potentially shifting to an approach that may reduce uncertainty for markets but lead to more interest rate volatility.

The makeup of the Fed will likely change significantly in the next few years

Charles Schwab

The Taylor Rule

So far, the administration hasn't nominated any candidates for the open seats, but some potential candidates' names have been floated, including John Taylor, the Stanford University professor who created the "Taylor Rule". The Taylor Rule is a formula for setting monetary policy. Advocates of the rule believe it should be used in place of the more discretionary approach to policy that the Fed has historically used because it may reduce uncertainty for markets and businesses. The formula focuses on the differences between actual inflation and target inflation, and actual Gross Domestic Product and potential GDP, otherwise known as the "output gap".

Its detractors note that potential GDP is unknowable and has fallen over the years, a development that the formula wouldn't capture easily. Also, since Fed officials work with real-time data that is often revised later, following the rule could lead to policy errors. These arguments aside, it appears that holding to the Taylor Rule over the past several years would have resulted in far more volatility in the federal funds rate than we saw. Fed Chair Yellen doesn't favor a rules-based approach, but future members might, which suggests that markets could become more volatile until the full makeup of the Federal Reserve Open Market Committee (FOMC) is known. The FOMC is the Fed's policy-setting committee and is composed of the seven members of the Board of Governors and five Reserve Bank presidents.

The federal funds rate would have been more volatile in recent years under the Taylor Rule

Had the Fed used the Taylor Rule over the past 20 years, the federal funds rate would have shifted more frequently in response to economic data, would have been steeply negative during the financial crisis and would be much higher today.

Charles Schwab

Facing higher rates

In the interim, the Fed appears to be on a path to hike short-term interest rates at least twice this year. By most measures, inflation is at or above the Fed's 2% target level and trending higher. Unemployment has fallen below 5%, under employment is at its lowest level since 2008 and wages are beginning to move higher, indicating that employers are being forced to pay more to find workers than in the past. Add in the potential for pro-growth fiscal policy and the case for moving interest rates higher seems compelling.

Inflation is above the Fed's 2% target by most measures and trending higher

Charles Schwab

The balance sheet question

The Fed has also begun to discuss how it will reduce the size of its balance sheet, now that the zero interest rate policy has ended. In the years following the financial crisis, the Fed's balance sheet ballooned to $4.5 trillion or about 24% of GDP in 2013 due to its bond-buying programs. Since then, the Fed has been reinvesting the principal and interest from its bonds and mortgage-backed securities to keep the level of assets flat.

The Fed is planning to reduce the $4.5 trillion in assets on its balance sheet

Charles Schwab

In its September 2015 publication, the Fed indicated that it planned to reduce the size of the balance sheet once the fed funds rate was between 1% and 2%. With two to three rate hikes this year, the fed funds rate should be right in the middle of that range, so it's logical that the Fed wants to have a plan in place to begin reducing its holdings. Moreover, with so much potential turnover on the horizon, the Fed may want to get the plan in place and communicate it to the markets soon so as to avoid too much disruption and uncertainty.

Our expectation is that the Fed will take a very gradual approach to the process, first trimming the rate of reinvestment and then gradually allowing maturing bonds to "roll off" the balance sheet. It's also possible that the Fed will try to use its reinvestments to smooth out the maturities of the bonds on the balance sheet. Currently, there is a bulge in maturing Treasuries in the next few years and then very little in the seven to 10-year range, and then a bulge with maturities of 10 years or more. Smoothing out the maturities could reduce the potential for disrupting markets in the short run.

A big chunk of the Fed's Treasury holdings matures over the next few years

Charles Schwab

The Fed also faces the question of whether it wants to return to a balance sheet of only Treasuries or whether it will continue to hold some mortgage-backed securities in the long run. Finally, there is the question of how large the balance should be in the long run. Some, including former Fed Chairman Ben Bernanke, have argued that the balance sheet doesn't need to return to the level seen prior to the financial crisis of less than $1 trillion. He has argued that since the economy has grown over the past several years, a larger balance sheet may be justified. At about 6% of GDP, the Fed's asset holdings on its balance sheet in 2007 was actually at the low end of the historical range. A level closer to 10% of GDP, while significantly lower than today's level, would still allow the Fed to have flexibility in setting policy when the next recession hits. Bernanke suggested assets of $2.5 trillion or more may be a reasonable goal over time.

What does it mean for bond yields?

For bond investors, all of these changes have the potential to push short-term rates higher. The Fed is already on the path to raising rates two or three times this year and if new members lean more toward following a rule-based approach to setting policy, the risk appears to be to the upside. The bond market, however, is sending a different signal than the Fed. Long-term bond yields have actually been edging lower recently despite the recent uptick in inflation and signals that the Fed is likely to raise rates. Moreover, the yield curve (the difference between short and long-term rates) has declined from its post-election peak. This could be a signal that the prospect of more Fed tightening is beginning to diminish long-term inflation expectations.

We continue to expect volatility will pick up in the bond market due to the increased uncertainty about fiscal and Fed policy and suggest investors continue to keep the average duration in their portfolios in the short to intermediate term. Longer term, we continue to see the potential for 10-year Treasury yields to rise to the 2.75% to 3.0% range later this year, but a lot will depend on who is chosen to join the Fed in 2017. For now, we suggest a cautious approach to the bond market.